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Dividend Policy

8- 1. Dividend Policy. Overview. Practical Aspects Benchmarking: Irrelevance revisited Policy Low dividends High dividends Policy refers to the tradeoff between paying dividends at a particular date versus paying on a different date - not about the level of dividends. Types of Dividends.

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Dividend Policy

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  1. 8-1 Dividend Policy

  2. Overview • Practical Aspects • Benchmarking: Irrelevance revisited • Policy • Low dividends • High dividends • Policy refers to the tradeoff between paying dividends at a particular date versus paying on a different date - not about the level of dividends

  3. Types of Dividends • Regular cash dividends • extra cash dividend • liquidating dividend • Stock dividends • increases number of outstanding shares • no cash flow • Stock split • similar yet larger than stock dividend

  4. Important Dates • Declaration date • Date of record • Ex-dividend date • Date of payment

  5. Irrelevance: Example • Consider a firm that exists 1 year and consists of only an expected cash flow of $10,000 at the end of the year and $10,000 immediately. The firm is all-equity financed with rE=10%. The firm will match its dividend payments with the cash flows. The firm has 1,000 shares outstanding. • V0 = D1 + D2 / (1+rE) = $10,000 + $10,000 / (1.1) =$19,090.91 • Share price = $19,09 (cum dividend) • Share price = $9.09 (ex dividend1) • Proposed new dividend policy is to pay $11 per share immediately. The excess cash needed is financed through an equity issue, again yielding a 10% return. • What is the value of the firm under the new policy? • At what price can the new shares be issued and how many?

  6. Answer • New shareholders require 10% and hence require $1,100 at the end of the year, leaving $8,900, or $8,90 per share, in dividends for the existing shareholders. • Share price for existing shareholders (cum dividend): $11 + ($8.90/1.1) = $19.09 • Issue price new shares = $19.09–$11=$8.09 (or $8.90/1.1) • Number of new shares offered = $1,000 / 8.09 = 123.61 shares • Assumptions for this irrelevance to hold: • no taxes or transactions costs (perfect markets) • homogeneous expectations • investment policy is independent of dividend policy

  7. Dividends and Taxes • Effective tax rate is higher on dividends than on capital gains • Firm with insufficient cash • transaction costs of financing & price pressure effect • tax effect of paying dividends • stability issue of maintaining a constant level • Firms with sufficient cash • Agency costs of free cash flow • Investing in financial assets (Tcorporate versus Tpersonal)

  8. Dividends versus Repurchases • Irrelevant under perfect markets • Tax benefit of share repurchases • Targeted Repurchases • Investment opportunity and signaling

  9. Expected returns and dividend yield • Pretax returns are increasing in the dividend yield • Dividend yield=annual dividends per share/share price • Empirical evidence is mixed • Dividend yield is highly correlated with Book-to-Market • Should firms have High or Low Dividend policies? • Current income • Uncertainty • Tax arbitrage • Agency costs

  10. The Information Content of Dividends • Results so far: • Irrelevance because of homemade dividends • Low dividends because of taxes • High dividends because of current income etc. • Empirical evidence: • Stock price is positively related to changes in dividends • Consistent with . . . .? • Or . . . .? • Signaling and the information content of dividends

  11. Other issues • Clientele effect • Different tax brackets result in demand for different levels of dividends • Value creation can only occur if dissatisfied clientele exists - unlikely! • Despite taxes - dividends are substantial • Decline in the number of dividend paying companies • Dividend smoothing

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